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Today, Facebook is indispensable for many of us. We use it to keep in touch with friends, arrange events, share news, photos and music and, though we all say we don’t like adverts, find out about things we want to buy or visit. This year, it’s expected to reach the landmark of 1 billion users – that means that roughly one person in seven on the planet will have a Facebook profile.

Facebook’s popularity also makes it a business phenomenon. While its core concept is neither entirely original or unique, it does what it does better than any of its competitors and the place it’s thereby assumed in modern life makes it of huge significance as an advertising platform in the corporate world. Facebook’s ascendancy is also part of a larger story about the status of technology companies in the eyes of investors. Can these somewhat nebulous organisations, with none of the assets of traditional businesses like factories, large networks of stores or offices, or extensive armies of staff, convert their consumer popularity into substantial financial returns?

Things came to a head earlier this year as Facebook prepared for its long anticipated initial public offering (IPO), which finally happened in May. An IPO, also referred to as "going public", is where a company privately owned by one or more shareholders decides to offer shares in the business for sale to the public on a stock exchange, thereby raising funds for the business’s development but also subjecting itself to the pressures of public scrutiny of its accounts and a constantly fluctuating quantitative market valuation. Facebook’s IPO represented both a new pinnacle of achievement and a significant test for the company: it might have lots of users, but how much was the business really worth, and what might its future hold?

How to win friends

To understand how the IPO could start to answer these questions, it’s necessary to go back to the basics of Facebook’s business model. As anyone who’s seen the film The Social Network will know, Facebook was set up in 2004 by current chairman and CEO Mark Zuckerberg and four classmates while all were undergraduates at Harvard University. It was originally an online version of the student profile publications produced at Harvard and other elite Ivy League institutions, but quickly expanded to offer its services to other US universities, colleges and schools worldwide, and finally to anyone over the age of 13.

Facebook was not the first online social networking facility – sites doing broadly comparable jobs set up around the same time or earlier include Friends Reunited, Bebo and Friendster, and Zuckerberg’s own earlier creation, Facemash. Facebook’s biggest early competitor, however, was undoubtedly MySpace, which held a dominant position in the online social networking sphere in the mid-noughties and at one point even surpassed Google as the most visited website in the world. But business success can be achieved with a superior version of an existing idea, as Facebook has amply demonstrated.

"Facebook overtook MySpace and Friendster because the user experience was so much better," says Malik Aberkane, a strategy consultant at social media specialists Carve Consulting. "On MySpace a few years ago, if you wanted to build your profile by, for example, uploading a background picture it was really hard if you didn’t know how to use a coding language. On Facebook, you have a really user-friendly interface – anyone can post pictures easily." Malik also thinks the pace at which Facebook took the online social networking concept forward was critical to its success: "During their first three or four years," he says, "they introduced a real innovation to improve the product every few months, while MySpace remained the same. A few years ago if you wanted to interact with someone on Facebook you could only post on their Wall, but now you can comment on their status updates, answer their comments, like their comments, message them directly, and now they’ve introduced a video chat facility." As Christophe Mallet, also a strategy consultant at Carve, recognises, it was this constantly increasing multiplicity of communicative options on Facebook that was crucial to its eventual displacement of MySpace: "The proposition of MySpace is you have a website on which you can put whatever you want and then you can add some friends, whereas Facebook is this place where you can connect with people you know."

Reaping the rewards

So Facebook provided a better user experience than its competitors and thus rapidly grew its database of members up to the 1 billion mark it’s forecasted to reach this year. But how does this success translate into business viability – in simple terms, profits? Christophe explains: "The value of Facebook is its users’ data. Each user has a location and interests, likes artists and brands, and connections. About 85 per cent of Facebook’s revenue comes from selling this data to advertisers so that advertisers can undertake targeted advertising, which means saying, ‘I want [to reach] people who are between 18 and 24 living in London who like football’, for example. That’s what Facebook sells." Most of the remaining 15 per cent of Facebook’s revenue comes from games like Farmville, which are usually free to play initially and then charge users for extra features once they’re hooked.

Evaluating Facebook’s worth as a company is not as simple, however, as looking at its incoming streams of money from advertisers and users. Christophe points out that Facebook’s $3.7 billion (£2.4 billion) of sales in 2011 translate to only around $4 a year for each user – which is not that significant. Instead, says Christophe, the true value of Facebook "lies in the belief investors have that it’s going to be able to monetise [user] data further". Valuing a large and complex company such as Facebook is a domain in which investment banks specialise, and Ben Canning, Head of UK Equity Capital Markets at BNP Paribas, agrees that the process of valuing Facebook is dependent on how you see its future: "Normally investors look one or, at maximum two, years ahead but in the case of Facebook you’ve got to look many years ahead. It’s all about the potential. Today you look at how many unique users it has, how many hits, and then try to guess where advertising revenues might go."

So if Facebook’s current value is dependent on the belief of investors that it can fulfil potential that’s still dormant in its business model, it needs to continue on the trajectory of rapid growth and innovation that has characterised its story so far. Enter this year’s IPO, a major milestone on this path.

Public interest

Why and when do companies typically choose to go public? Ben explains: "Every business reaches a point in its life cycle where to keep growing it needs to go beyond its internal sources of funding. Its own profits and cashflows can take it so far, but then you need to get external financing. Usually the first step taken is investment from private equity or angel investors, as Facebook has done. As a company matures and grows, it may then start to access debt financing from banks and bond markets. Usually the next stage is to do an IPO and get access to public equity investment."

And what prompted Facebook specifically to go public? Says Ben: "Facebook is a company which is about potential but not yet about profits and therefore probably couldn’t currently service too much debt. Therefore the money it needs to grow and keep investing in products and services to compete with the likes of Google, Yahoo, Apple and Microsoft was probably always going to come from equity [selling shares] rather than debt." Technology companies often also undertake IPOs to allow those who were involved in starting the business to realise some of the value they’ve created – before Facebook listed, Mark Zuckerberg was a billionaire several times over on paper, but much of this wealth was tied up in his shares in the company. A further factor that will have influenced the decision is that, because it had accumulated over 500 private shareholders by early 2012, Facebook was essentially obliged under US corporate law to go public.

But to what extent is an IPO also a publicity exercise? It’s sometimes argued that businesses embark on an IPO in part to generate positive publicity in the business media that, with luck, can be converted into new opportunities and hence real financial value. "An IPO is an opportunity to do a great PR splash," says Ben. "When we’re working on an IPO, we’ll often hire PR consultants, and their job is to get the IPO (if it’s a large one) on the front page of the Financial Times or the Wall Street Journal, giving the company an opportunity to engage with customers, potential new customers, and employees," but he adds that he thinks IPOs are ultimately "more about raising new capital than PR".

However, it’s probably impossible to separate entirely the two sets of motivations in the corporate world, and certainly in the case of Facebook. Facebook’s brand is a crucial part of its financial value, as was evident in the hype that built up in the months and weeks leading up to its IPO, as Ben admits: "Facebook is a global phenomenon and everybody knows it – not just sophisticated financial institutions, but every person on the street. It has a huge brand name and a huge following, and everyone wanted a piece of it, which led to huge interest and demand in the IPO. I would argue nearly all of Facebook’s value is brand value/future value rather than conventional financial value." So Facebook’s IPO was a chance for the company to raise finance to fund its growth but crucially also to promote the company’s fortunes by continuing to tell the Facebook story of apparently almost unstoppable success and unlimited potential, judged so riveting that Hollywood made a movie out of it, and which is an undeniably important component of the company’s value to investors. And Facebook certainly embarked on the IPO with plenty of friends in the market prepared to back up their faith in the company with hard cash, but how much would they "like" how Facebook’s next step turned out?

Ups and downs

Facebook’s IPO was anticipated, discussed and analysed in relation to those of other high-profile Silicon Valley IPOs for years before it was finally announced to the markets. Meanwhile, behind the scenes, Facebook’s board must have been pondering their options and potential IPO outcomes. Many companies contemplating a listing hope that their share price will see an initial moderate rise followed by stabilisation. This trajectory rewards day one investors with a quick profit but doesn’t leave the company’s former private shareholders feeling they’ve sold a stake in their company too cheaply, the risk if a company’s shares rise in value very rapidly. Listing companies are therefore usually advised by their underwriters (the investment banks who assist the company with the financial aspects of the IPO and find initial investors) to choose an initial offering price for its publicly traded shares 10 to 15 per cent below a price reflecting what they believe to be the true market value of the company.

However, the IPO for Facebook to aspire to was always Google’s successful 2004 listing, which saw the search engine supremo’s shares rocket in value from $85 to over $100 on their first day of trading and to nearly $200 by the end of the year. Why? Because in the case of Facebook’s IPO, as with Google’s and that of many other technology companies, the company’s management and private investors intended to retain the vast majority of available shares, making a significant uptick in their value an unequivocal plus.

More recently, professional social networking site LinkedIn undertook an IPO last May and, while it hasn’t enjoyed a rise in value to match Google’s, its shares have performed moderately successfully. However, the listings of daily deals site Groupon and gaming company Zynga, both also in 2011, fell decidedly flat, and the share price of each has seen significant drops in value since then. A listing therefore, especially for a company in a volatile industry like technology, is a gamble. Says Ben: "In the world of today’s equity markets, if you can be successful in an IPO, then you stand out. Every time a company does a capital markets transaction there’s risk involved, as Facebook found out."

Growing pains

So how did Facebook fare on its IPO? And, to return to our original questions, what did its IPO mean for the viability of the business now, and in the future? Things looked bright in the run-up to the big day – 18 May 2012. Even though Mark Zuckerberg ruffled a few financier feathers by wearing a hoodie instead of a suit to a series of "roadshow" meetings with potential investors, expectations were high that the IPO would indeed represent another glowing chapter in the Facebook success story. Demand for shares was high, leading to Facebook announcing two days before the listing date that 25 per cent more shares than initially promised would be available, and the set price of $38 per share meant that underwriters felt the market valued the company at an incredible $100 billion, around twice as much Ford. Some analysts felt that the valuation was a tad optimistic, but few saw much other than spring sunshine ahead for the company on its public trading debut.

But the first day of trading in Facebook’s shares on NASDAQ, a smaller competitor to the New York Stock Exchange which specialises in hi-tech companies, was plagued by operational difficulties. Many traders saw their transactions delayed or cancelled, or were unsure whether or not their trades had gone through the system, which is hugely problematic in the fast-paced world of trading where participants have to keep up with markets that change every second.

It certainly didn’t look good for a technology company to be affected by technological issues but Facebook could justifiably claim that the NASDAQ malfunctions weren’t its fault, and is currently suing the exchange for compensation. However, after these glitches had been dealt with, more serious problems awaited – after an initial surge to over $40, the value of the shares plummeted over the rest of May to a low of around $29 by the end of the month. What had gone wrong? Was Facebook simply slightly overvalued by its underwriters or, more worryingly, had the market stopped believing in the Facebook fairytale?

"I’m quite certain", says Ben, "that the bankers involved went out and sounded out the market to see what investors thought the company was worth and if they had simply applied too high a valuation, the shares wouldn’t have sold. But the shares did sell at the initial price." What went wrong then? "It was less to do with a faulty assessment of demand and more to do with complex disclosure problems", says Ben. As part of the pre-IPO process, a company proposing to list its shares must issue a lengthy document, known as a prospectus, providing the information needed by potential investors to enable them to decide whether or not they want to buy the company’s shares when they become available and, if so, how many. Very late in the pre-IPO process, Facebook significantly lowered their forecasts of the amount of revenue they expected to derive from certain types of advertising. Unfortunately, not everyone in the market saw this update before the IPO took place, leading to some disgruntled selling of Facebook shares by investors and hence their drop in price as the information filtered through the market. As a result of this slip-up, Facebook is now facing a lawsuit from a group of powerful investors angry that this key information was, allegedly, hidden from them.

Forward thinking

Facebook’s golden legend was undeniably tarnished by the controversies initially surrounding its float, but are things looking any brighter now for the company a few months in? Its share price rose during the first weeks of June to well over $30, but it then began to fall again, reaching a new low of around $23 at the end of July shortly after the company’s 2012 second quarter results revealed losses of $157 million for the period. However, these losses were mostly due to expenses related to the IPO, and it’s still very early days for Facebook’s career as a public company. Some analysts believe that turbulence in Facebook’s share price may simply represent the teething troubles that are standard for many new public offerings, rather than the beginnings of a terminal fall from grace. As Ben points out, for most public companies, "the biggest period of volatility is immediately after a float – it takes some time for the share price to find its natural level".

While it’s somewhat hard to predict with accuracy how Facebook's share price will fare in the coming months and years, what is certain is that being a public company will change the business. "It’s going to give it more access to capital," says Ben, "but the cost is to remove a degree of flexibility in the way the company operates. It’s going to have many more shareholders, so certain new rules will apply which may slow certain large decisions. It’s also going to have to disclose more to the market and produce full and detailed annual reports." Will the administration and scrutiny involved in being a public company reduce its ability to innovate and, crucially, to portray itself as innovative, both of which have historically been at the core of Facebook’s success? Says Ben: "It’s now going to have to act like an adult business rather than a teenager in a garage, but I think Mark Zuckerberg can keep his hoodie and won’t become a tie-wearing corporate clone. There’s no reason to think that its Silicon Valley culture will have to change – there’s a whole host of listed companies now who are full of hoodie-wearing young folks trying to come up with the next new thing, and being listed doesn’t stop them doing that."

There are, however, significant challenges ahead for Facebook. The key one is proving that it can realise its purported value by delivering on the belief that the market appears to have in its revenue-generating potential. "The question", says Christophe, "is how Facebook is going to be able to monetise the data they have" – that is, make its advertising revenues match the size of its user base. One significant problem Facebook faces in attempting to generate advertising revenue is that it hasn’t yet found a way to display adverts on the versions of the site viewed on mobile devices. For various technical reasons and also simply because of the narrower width of the average smartphone compared to that of a laptop, finding a way to display adverts that strikes the right balance between effective and unobtrusive is proving a difficult issue to solve. It’s an issue that Facebook must tackle, however, not least because growth in its user base is likely to come from African, Asian and South American countries in the future, where it’s common for users to access Facebook’s services through these devices alone. Another significant curb on potential growth in advertising revenue from new emerging markets users is the continued closure of China to Facebook – the Chinese government refuses to allow it to operate in this vast country which means that its Chinese competitors, most notably Renren, have been able to seize a sizeable share of this potentially hugely valuable market.

A further complication for Facebook’s efforts to raise its advertising revenue is that its existing users are, by and large, hostile to intrusive advertising on what they see as a social, rather than commercial, online space. For this reason, Facebook is at a major disadvantage to Google, one of its most significant competitors, as Christophe explains: "When you’re on Facebook, you’re not looking for something. You’re there to talk to your friends, which is why Facebook ads tends to perform less well than Google ones." Particularly as it tries to make more money out of targeted advertising, Facebook also faces the ongoing thorny issue of ensuring it doesn’t breach its users’ legal rights to privacy.

It’s not just commercialisation of the site that has the potential to turn existing users off Facebook. Many subscribers in the US and Europe, now relatively long-term "friends" of the site, are suffering, Christophe believes, from "Facebook fatigue". Facebook’s very success at attracting consumers may, paradoxically, now be a hindrance in some ways: "It’s not just your real friends on it any more", he explains, "– it’s become annoying because you’re now connected to your boss, your mum, your ex-girlfriends, even brands. So a lot of people are starting to realise that, though they’re addicted to Facebook, it doesn’t bring much to their lives." Will Facebook fatigue see the number of users in the US and Europe dropping? Christophe thinks not – users may not use features such as news feeds so much in the future but, because of the depth of its market penetration (how many people do you know who haven’t signed up?), it will remain indispensable as an address book and event organising tool for some time to come.

Ben, however, sees the possibility of consumer disenchantment as a very serious business risk for the company: "Facebook’s got very loyal customers/users but in my opinion it will need to diversify its product offering. Today it has one core product and so there is a risk concentration. Can you imagine what might happen if one major uncool mistake was made? One major misuse of information?" He thinks that, to protect itself, Facebook should follow Google and Apple’s lead and develop new products and services to complement its core offering and provide backup revenues should the original site suffer a serious PR disaster: "If you look at Apple," he says "it started off making desktop computers, but now makes phones, other devices as well, and also iTunes selling the music content."

Cool runnings

"Watch this space for material new services from Facebook, now that they have IPO money to spend", says Ben, drawing attention to how the company seems to be using the cash generated from its IPO to effect the diversification he recommends. Its most notable step in this direction so far has been its purchase of photo-sharing app Instagram in April this year. He suggests its next steps might include making further acquisitions or investing in joint ventures to develop a rival product to the iPad or even its own mobile device – rumour has it that a "Facebook phone" might be on the market as soon as this December. It seems probable that the launch of such a product might be coupled with a solution to the problem of developing an effective advertising platform for these devices.

Facebook also seems likely to develop its offering to advertisers by giving them even more targeted opportunities to reach their ideal consumers – which may also simultaneously help to ward off Facebook fatigue as users will be more likely to see adverts of particular interest to them. And as a further step to appease users, Christophe and Malik think that Facebook might develop its Timeline feature, offering users more personal space on the site. In doing so, Facebook would be following the lead of some of its peers, most notably Pinterest, a revived MySpace, and also its own Instagram, where networking is primarily based around sharing interest-related content rather than connecting with people you know in real life. All these initiatives to move the business forward will require more hands on deck, so expect Facebook’s headcount to continue to increase rapidly.

So it looks likely that there are at least a few more exciting chapters in the Facebook story to come. And despite a choppy listing and the challenges it faces, there is still belief in the market in the future of a business that, revenue-wise, has yet to fulfil its potential. But Facebook has to eventually come good on this belief and produce sizeable profits as well as inspiration for Hollywood movies in the coming years. Doing so will mean balancing the fulfilment of its obligations as a grown-up public company to its advertiser clients and investors with retaining the cool image and popularity among young people that is such a crucial part of its value to them.  

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